Recent declines in global trade are benign, but storms are brewing

 The freeing up of trade, which has been the single biggest source of Western prosperity since 1945 and of global growth since the late 1970s, is taking quite a kicking. Brexit, Trump, even the shambles over the Canada-EU trade and investment deal all point in the direction of rising protectionism. Meanwhile global trade itself has been in decline for the past two years. What is going on? Is it “game over” for free trade and thus globalisation?

Earlier this month, when Wallonia, a small province of Belgium, blocked the trade deal between Canada and the EU, albeit temporarily, it was just the latest in a series of setbacks.  In June, the United Kingdom voted to leave the European Union, the world’s largest free trade area, in what Martin Sandbu, economics editorial writer for the Financial Times, has termed “an act of protectionist vandalism”.  Now the newly-elected Donald Trump says he will renounce the Trans-Pacific Partnership, his predecessor’s trade deal involving the USA, Japan, and ten other countries in Asia and Australia, on his first day in office. Trump is also threatening to pull out of the North American Free Trade Area which he has called “the worst trade deal in history” and has pledged to raise tariffs on Chinese goods to protect American jobs. In this climate, few believe that the Transatlantic Trade and Investment Partnership (TTIP), which is under negotiation between the USA and the EU, has much of a future.

This shift in attitudes comes as there are ominous signs of a decline in global trade. The share of exports as a proportion of world GDP is now falling (see Chart). Some might see this as a consequence of protectionism. Actually, it reflects an adjustment that could prove good for globalisation – if political leaders pay attention to it.

Although there was a modest increase in protectionist measures during the financial crisis, the World Bank thinks that only 2% of the fall in world trade at the time was attributable to this.  Overall tariffs for most major economies have either been stable or falling in recent years.  Even if you consider non-tariff barriers, they too have mostly been stable over the last ten years.

Instead, a cluster of other reasons lie behind the change.  Partly it is down to slowing growth in China, because lower growth means fewer imports of raw materials and the like.  But economists at the IMF think the decline is mostly due to changing patterns of vertical specialisation.   In other words, over the past few years, world trade exploded as global supply chains relocated parts of their production process to different countries.  As an example:  iron ore dug up in one country was exported to another to be turned to steel, sent to a third to be melted and cast into the shape of a car door, sent to a fourth to be assembled into a car, and shipped to a fifth to be sold. Now, at least in the gigantic case of China, this trend appears to have played itself out and is going into reverse, thanks to increases in the cost of production.

Trade is driven by the forces of absolute advantage (the ability to produce at a lower unit cost) and comparative advantage (the ability to produce at a lower opportunity cost).  Fifteen years ago when China joined the WTO and opened up to world trade these advantages were enormous.  But as their economy has grown and incomes have risen, these advantages are no longer as big.  At the same time Chinese companies are now increasingly producing to meet domestic demand rather than sell the goods overseas.  A similar phenomenon may be happening in places like India and Indonesia.  The economist Walt Whitman Rostow had a name for this stage of development : the Drive to Maturity, during which growth spreads to other sectors and is increasingly driven by meeting consumer needs.

There may also be a couple of less recognised factors at play.  The shale gas revolution in the US has dramatically reduced that country’s imports of energy.  This in itself can help explain part of the drop in US imports (see Chart).

Recent falls in world trade are little cause for concern but mostly part of a desirable new phase of development.  Meeting the needs of these enormous emerging economies will create huge new opportunities for Western companies whether it be in providing Burberry handbags or Microsoft Office to an expanding middle class.

If this is right, there may be an irony in the recent hardening of attitudes towards free trade.  Opposition to trade is intensifying at the very moment when the disruptive threat from emerging economies may be waning and new opportunities emerging.  But that is not a reason for complacency.  The benefits of free trade in increasing growth, raising incomes and enhancing welfare are powerful and well-established.  Those, like Donald Trump and many supporters of Brexit, who oppose it must be countered, or we risk a much less benign slump in world trade – one that will harm everyone.

Edited by Bill Emmott